Top of the Morning: Fixed Income Strategist - Navigating through the fog
The desk believes that fixed income assets are navigating a complex landscape, influenced heavily by the Federal Reserve's interest rate outlook. Per the full note from UBS, a key takeaway is that while the consensus expected higher interest rates due to strong growth signs, figures suggest volatility could alter this trajectory as trade policies come into play. The current yield forecast indicates stability might be reached at around 4.25% for the 10-year Treasury, aligning with UBS's previous outlook. Institutional traders should monitor how positioning shifts ahead of economic data releases as markets gain clarity.
What the desk is arguing
The desk posits that fixed income assets are at a critical juncture with respect to interest rates, shaped significantly by upcoming monetary policy decisions. Per the full note from UBS, the market is coming to terms with potential volatility linked to trade policies and their implications on growth, which directly impacts bond performance.
The UBS forecast that the 10-year Treasury yield could stabilize near 4.25%, reflecting an acknowledgment of the unexpected shifts prior in the year, emphasizes the need for traders to maintain a close watch on macroeconomic indicators and central bank guidance. This level could serve as a pivot point, balancing the anticipation of tightening against ongoing economic challenges.
Where it sits in our coverage
Our consensus target for the 10-year Treasury yield is currently set at 1.075, with a range between 1.04 and 1.12. Specifically, looking at the competition: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
The desk's outlook falls slightly below the consensus target of 1.075, indicating a cautious stance against the more optimistic views from some firms.
How other firms see it
Firms like jpmorgan appear aligned in their bullish outlook for fixed income assets, while bofa presents a more conservative stance, indicating divergent beliefs on the future of interest rates and their impact on market liquidity. The volatility anticipated in fixed income relates closely to movements in USD/JPY and future Federal Reserve policy decisions as traders reassess risk sentiment.
01The outlook for fixed income assets is influenced by potential volatility linked to trade policies.
02The consensus anticipates stabilization of the 10-year Treasury yield around 4.25%.
03Caution is advised as traders await further economic data releases.
04Divergent views on interest rates among firms highlight differing risk assessments in the market.
Market implications
Traders should be vigilant for any shifts around the 4.25% mark in the 10-year Treasury yield, as this could signal changes in market sentiment. Additionally, upcoming economic data releases could serve as catalysts that either reinforce or challenge the current yield assumptions.
Risks to this view
A sudden shift in monetary policy from the Federal Reserve, unexpected economic indicators, or significant developments in global trade relations could invalidate the current fixed income outlook and prompt a reassessment of yield forecasts.
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Hi everyone, Carly Torres here, and welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today's conversation, we are focusing on fixed income strategy, which coincides with the release of the most recent fixed income strategist report from UBS Chief Investment Office. For today's conversation, we will be discussing second half positioning considerations, outlook for the asset class, and discussing some recommendations.
Joining me today for the conversation, I'm excited to welcome back Leslie Falconeo, Head of Taxable Fixed Income Strategy Americas in the UBS Chief Investment Office. Great to be here with you today, Leslie, and thank you so much for joining us. Thank you for having me.
This month's report was very thorough and insightful, so let's get straight into it. Can you summarize your outlook for interest rates in the second half of the year? Sure.
So, as our readers know, we came into this year, and we were actually probably one of the outliers, because we came into the year thinking that at the end of the first quarter, we would end, the 10-year would end at around a four-and-a-quarter yield, and at that time, you were in the euphoria of this red sweep and pro-growth and U.S. exceptionalism, so we were actually sort of, we were a bit of an outlier in the sense that the expectation was the consensus was that interest rates were going to rise because of this stronger growth kind of outlook, because of the tailwinds of the equity market. And while everyone, or most people, knew what the policies would be, what we didn't know was the sequence, the duration, or the depth, so lo and behold, as some of these policies came through, as we know, particularly those in regards to tariff and trade, the market became a little bit more volatile, and it actually ended up hitting close to our, actually our first quarter target of the four-and-a-quarter. Now, when we think about where we are in the second half of the year, one of the things that we've kind of discussed is that while volatility might still be in play every once in a while, there's a lot of now known unknowns, meaning that we don't, we are anticipating more of the economic data to really be the guide to the U.S.
Treasury market versus political rhetoric or speculation. So when we think about the second half of the year, our outlook, and frankly, this is no different than most people, is that this growth will slow, growth will slow given the fact that consumer, which has been a really big driver because the household balance sheets are strong, and let's remember that, you know, U.S. economy is a service-driven economy, not, you know, it's not goods, it's services, so, but we anticipate the consumer will probably end up pulling back a bit because they front-loaded some of these potential implications that tariffs might result in, so we have growth slowing in the second half to, you know, probably to end the year at a 1.5% Q over Q GDP, but in order to get that, you know, the third quarter will probably be quite slow. So given that outlook, we do anticipate that, you know, interest rates at the end of the year will trend towards that 10-year yield will be 4.4 in a quarter, which really isn't that different than, you know, what we saw at the end of the first quarter, but the caveat is how this inflation story, you know, kind of plays out, and it's our expectation that this is more of a one-time adjustment, not a long-term trend, and as we have some numbers yesterday at CPI and PPI, you know, one was a bit, none of them are sort of outliers in terms of increase in inflation, but again, it's a bit too early to make the assumption that this won't have any implications because we need to see the next couple months of data, and with that said, you might have these pockets of interest rates rising, which we believe they will, right?
So, you know, it could be a 4.75-10-year yield, it could be a 4.80-10-year yield, but we just don't believe it's sustainable, and we look for interest rates too slow in the second half of the year given the slower growth and our expectation that the Fed begins to cut in September. Great, and with that topic of looking towards the future, what are your main expectations for U.S. Treasury performance going forward?
Well, that has really been the key this year, and when we think about, and one of, you know, one of the things that I want to point out is that, you know, we have been, and the yield curve is going to steepen, can't remember, this is after two years of an inverted yield curve, over two years. We had a yield curve that was going to steepen, we put that on in just a little bit beyond the second half of the 2024, okay? So our expectation was after years of an inverted yield curve, you know, the Fed would cut, the curve would steepen, meaning that the short end would outperform the longer end regardless if you were bullish or bearish, and, you know, we really held that view, and lo and behold, we've had this pretty big steepener.
Now, what we've seen is that, you know, although it's, again, this was known given the red sweep that you'd have a rise in the deficit, what we've seen is an underperformance of the back end of the yield curve fairly dramatically. So if I look at how yields have changed, say, from the beginning of the year until now, I might have a five-year treasury that's down 40 basis points, but I have a 30-year treasury that's up 10. So that is a steepening, but it's also a steepening where the back end is really starting to underperform.
So when we held our positioning, we really recommended to stay in that intermediate part of the curve, in that five-year part of the curve, and we got long that right after the election, right, for two reasons. One is because after the election, you know, yields had gone up, and number two was that our expectation was that the Fed would cut in 2025, and when they do, the five-year yields lead the way down. And number three, we didn't like that back end of the yield curve, right?
We wanted to stay away from the back end. So as we went to the April Liberation Day and the five-year treasury yield had gotten to around a 370, which is the low of the year, we shed that long in five-year. And now really what we're doing, we're waiting to extend our interest rate risk, that although we do believe that 4.25 is going to be by the end of the year, it's not necessarily going to be a straight line, and you're going to have pockets of vulnerability along the way, and one of the things that we're doing is that we're waiting for that, say, between 4.60 and 4.80 to actually extend our duration out, meaning that those are the levels that we think that 10-year treasury yield becomes attractive.
So we'll move from five-year to the 10-year. So right now we wait a bit, but our objective is to extend the yield rise with the expectation that the end of the year, the end lower, and into the first quarter of 26 as gross flows and the Fed cut. And thinking about what investors should consider, how do you see inflation trends impacting fixed income markets right now?
Well, they're not. I mean, that's really the key here, because we have to remember that investors had first, when these tariffs were put on, particularly, again, you know the depth and the duration, that was a surprise to the marketplace, not necessarily tariffs, but how they were implemented or quote-unquote advertised was the volatility to the marketplace. And initially people had thought, okay, we're going to go back into this 2022 scenario where when interest rates rise, they're rising due to inflation and not growth.
And as a result, the equity market goes down and the credit market, like high yield or loans, spreads widen. Well, lo and behold, what we've seen is actually an equity market, as we know, has had a tremendous recovery and has done well this year, meeting new highs. And frankly, the high yield market, while it's widened out recently, has reached a 270 percent spread and around a 240 is a 25-year tight.
So right now, inflation or inflation expectations is not a headwind to total return and performance to fixed income markets. And in fact, I mean, one of the things that we talked about in the strategist was that taking a more defensive stance this year, meaning that I have FOMO, too much volatility, I'm going to park my cash in a cash alternative like a money market fund or a three-month T-bill. Actually, that has not been overall the winning strategy because we've had fixed income, high yield, IG, securitized product actually all outperform, right?
And they're offering, obviously, very good compounding income. But when we're at these tight yield levels and spreads, right, and we're going into a period where we should see inflation or the result of tariff inflation come into the marketplace the next couple of months, then when we see yields rise, it will be because of inflation. And that expectation would be that you're going to have spreads widen out, right?
So not only are they coming into a tight level, but now we're coming into the inflation component. And probably when yields rise, it's not going to be because, okay, growth is so great. It's going to be because inflation is rising and so spreads are widened.
So we haven't seen it yet because there's been huge demand technicals. There's still strong fundamentals. But that inflation component is probably going to rear its head in the next couple of months.
And as a refresher, can you explain your view on investment grade versus high yield bonds at this time? Yeah. Listen, high yield has outperformed investment grade corporates this year by, you know, I would say a couple percent.
I mean, you know, if I look sort of like the last time where we think about where high yield has is trending around, I would say, you know, it's around a 4.7 sayish total return while, you know, investment grade corporates is about a 4 percent. I mean, not a huge difference, but, you know, the difference has been one of the reasons why high yield has outperformed is a few of them, one, where it's positioned on the yield curve, right? The high yield has index has a positioning at the three-year part of the curve.
And as we just talked about, it's been that short end where yields have really come down, right? So you have the benefit of declining treasury yields, right, which leads to price appreciation. So that's part of it.
The second part is, is that, you know, the fundamentals and high yield is strong, but they've turned their debt out. They have their better quality used to be. Leverage is low.
Corporate balance sheets are strong. So all of them has been, and not to mention, you know, at one point in time you were earning over 8 percent yield, which is a great carry component and a compounding in component, which is a good tailwind to your total return. Now all of that, right, and a technical bid and supply being lower had led to this really tightening in high yield.
Now IG, while tightening as well, to IG it's gotten about 80 basis points-ish. The low, 25-year low is around 77, 75. So investment grade corporates have done really well also.
They've benefited from yields coming down, but their positioning is not as strong as high yield is. But yields have come down. They've benefited from, you know, the technical bid that we've seen in the marketplace, not just domestic but also abroad, has been a big part in terms of, you know, helping high yield spreads stay compressed because, you know, supply, that supply is a bit lower.
We have a lot of buyers. Fundamentals are strong. But again, both of these asset classes, right?
We wouldn't label in the cheap category, right, because spreads have tightened so much. And one of the reasons why we're choosing, say, a high yield, excuse me, an IG over a high yield is not because high yield we think is going to come to some catalyst, right? It's just that right now if I could get, you know, around, say, a 5%-ish yield for investment grade and given the fact we do believe that, you know, the economy slows in the second half, given the fact that there's a higher correlation to high yield and equity, we've seen equity do really well, you know, it's a better sort of, you know, I'll say quote unquote hedge, if you will, to go to the higher quality product.
So this is why we think we're going into, this is why we like investment grade corporates. But again, you're not going to see a lot of spread compression. This is really about compounding income, which will be a good tailwind to total return in the second half.
And if, in fact, we do go to that 4%, 4.25% tenure at the end of the year, you're going to be able to get some price appreciation as well. And finally, Leslie, what risks should investors be most aware of in fixed income today? Look, I mean, I think, you know, first of all, you don't have, we have a lot of yield cushion, meaning that because you have the ability in fixed income, and that's why people buy fixed income, for income, right?
It's in the name. So, I mean, what we have a lot of income that you can generate through the fixed income market, given where yields are, okay? And because of that, you have a large cushion with how much interest rates could rise.
So for example, if I buy a high yield at 7.5%, I would need like that, you know, that part of the yield curve to rise 150, 200 base points before I wipe out a year's worth of income. So you have a lot, a lot of cushion on the carry basis. On the spread side, not so much, right?
Because we're seeing the fact that we've come in, you know, with this, it's, we've sort of gone against the grain in terms of the volatility that was expected due to a lot of geopolitical risks, the trade, you know, uncertainty regarding the data between soft data and hard data and the economy. But you've seen really this fixed income actually perform quite well and volatilities come down. So the risks are, is that more of, I would say, not to the degree of a 22 scenario, but more of a yield start to rise, but they're rising because of inflation.
And if they rise because of inflation, I don't have the support of a Fed cut, which is, you know, something that would help stimulate rates for the Fed to stand hold for longer. That's the first thing. Interest rates are going to rise, which, you know, prices are going to come down, but you're also going to have spreads widen if the interest rates are rising because of inflation, right?
Because then that really has, you know, a headwind to the overall performance of the economy, right? So that's, in my opinion, a risk that while we have not seen inflation rear its head, if inflation stays higher or goes up and it stays there and it's not a one-time adjustment, then interest rates are going to rise, Fed will not cut, and you're going to have a lot of headwind in terms of spread widening. And just because your cost of capital, your borrowing costs for these corporations are much higher, right?
Or are staying high, and that's really not expected because people expect the Fed to cut. Thank you, Leslie. I encourage you all, our listeners and our clients at UBS to give this publication a read.
Again, we've been referencing the report Fixed Income Strategist for the month of July. Leslie, thank you so much for stopping by and sharing your insights with all of us. And I'm looking forward to our next conversation together.
Thank you. Thank you. Thank you very much.
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